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ABC Ltd has made a takeover bid for XYZ Ltd. ABC's share price has been performing well in recent months, as the market believes that Mr Lord, the CEO of ABC, has the ability to strengthen and improve the performance of ABC.

XYZ has, however, been an erratic performer in the recent past. The acquisition is believed to be sensible in commercial terms. However, the market does not react to the terms of the bid in the manner in which Mr Lord had anticipated and, to his dismay, he found that the share prices of ABC had begun to fall.

A summary of the financial data of both the companies is presented in Table 9.

Mr Lord had estimated certain financial data (see Table 10), on post-acquisition basis.

The offer made is 10 shares of ABC for every 15 shares of XYZ. At the time of bid announcement, no information was released to the general public, other than the bid terms. There was however one comment by Mr. Lord that he "hopes to turn XYZ round".

Part A: i) Suggest how Mr. Lord might have computed post-acquisition values.

ii) What according to you would be the post-acquisition share price?

iii) Should the bid proceed? (12 marks)

Part B: Later, it is announced that the proposed merger is expected to result in the following: Immediate savings in administrative costs — Rs 5,00,000; realisation on sale of redundant assets by the end of first year — Rs 10,00,000; increase in net income per annum, in future — Rs 7,50,000. All these figures are net of tax.

Independent of Part A: i) Explain how this new information would affect your estimate of a probable post-acquisition share price; and ii) State your views on the bargaining power of XYZ. (8 marks)

Solution: i) Statement showing the manner in which Mr Lord would have computed post-acquisition values: The estimates as seen by Mr Lord show that he expected the market capitalisation (post-merger) to be at Rs 125 lakh.

Step I: Earnings of ABC — Rs 2,50,000; PE ratio of ABC — 12.50; market capitalisation of ABC — Rs 31,25,000; number of shares outstanding of ABC — 5,00,000; price per share — Rs 6.25; earnings of ABC — Rs 2,50,000; earnings of XYZ — Rs 7,50,000; combined earnings (a) — Rs 10,00,000; presently, PE ratio of ABC (b) — 12.5; market capitalisation (a) x (b) — Rs 125,00,000.

It appears that Mr Lord has applied the current PE ratio of ABC to the combined earnings of the two companies after merger, as follows: Number of existing shares — 5,00,000; new shares to be issued — 10,00,000; total number (a) — 15,00,000; market capitalisation as computed in Step I (b) — Rs 125,00,000; share price expected by Mr Lord (a)/(b) — Rs 8.33

Observations: Admittedly, this is not the correct approach.

ii) The most likely share price can be based on combined market capitalisation of both the companies, as they exist now, factored into the number of shares that would be outstanding:

Market capitalisation of ABC (Step I) — Rs 31,25,000; market capitalisation of XYZ (earnings x PE ratio) (7.50 x 7.50) — Rs 56,25,000; total market capitalisation (a) — Rs 87,50,000; total number of shares that would be outstanding (Step I) (b) — Rs 15,00,000; likely price per share (a) divided by (b) — Rs 5.83

Likely price is Rs 5.83. Hence, the share price of ABC is showing a downtrend (to the dismay of Mr Lord)

iii) Should the bid proceed? We may analyse the gains or losses in this transaction. For the shareholders of XYZ:

Number of shares (to be issued) — 10,00,000; value per share — Rs 5.83; total value — Rs 58,33,000

There would, however, be a value loss for the shareholders of ABC: Pre-bid market price as shown in Step I — Rs 6.25; value that will emerge after merger — Rs 5.83; loss per share — Rs 0.42; aggregate value loss (0.42 x 5,00,000) — Rs 2,10,000

The post acquisition share price would settle at Rs 5.83. This will mean a value loss to existing shareholders of ABC.

From the point of view of existing shareholders of ABC the bid is not favourable and they are placed at a disadvantage. Hence, the bid should not proceed. But as the announcement has already been made, the bid cannot be stopped at this stage.

Part B: i) The likely impact on share price, taking certain synergies announced later, will depend on the value of combined equity, which is as follows: Immediate savings (seen to be one-time) — Rs 5,00,000; realisation on sale of assets, discounted at 15 per cent for one year (factor 0.869, taken as 0.870) — Rs 8,70,000;

income improvement (seen to be perpetuity 7.5 capitalised at 15 per cent) — Rs 50,00,000; value of synergies — Rs 63,70,000;

combined value of the two firms as they exist now — Rs 87,50,000; total value, taking all benefits into account — Rs 151,20,000; number of shares (including new shares issued) — 15,00,000; value per share — Rs 10.08.

The share price is, therefore, likely to change further. And once the market knows the information on synergies fully, the price will move up to Rs 10.08.

The likely price after taking synergies into account is Rs 10.08.

ii) Bargaining power of shareholders of XYZ: On the face of it, much bargaining power is not seen in the hands of XYZ shareholders at this stage, as they have already been given an added value of 0.42 paise, which is the loss for ABC.

However, the bargaining power of XYZ shareholders would depend on whether or not there are other predators, that is, any other prospective buyers who may be desirous of XYZ and who are also aware of the likely benefits. If any other company makes a bid for XYZ and if the value of the bid is higher than what has been offered by Mr Lord already, then the hands of XYZ shareholders would be strengthened.

In such an event, ABC may have to pay an even higher price, than what has already been proposed.

Project choice

SS LTD has identified three possible investment opportunities. SS' directors have, however, decided not to incur capital expenditure beyond a ceiling of Rs 4,00,000 for the current year. The projects, listed as A, B, and C (see Table 11), can neither be scaled down nor postponed. There are no residual values either. While preparing the cash-flow estimates, the chief finance manager has inadvertently not taken the annual inflation factor of 10 per cent. The company's shareholders expect a return of 15 per cent nominal, on their investment.

Required: i) Compute the expected NPV and profitability indices of the three projects; and ii) comment on which project(s) should be chosen for investment, assuming that the company can invest surplus cash at 10 per cent in the money market. (10 marks)

Solution: The statement showing computation of NPV and profitability index:

Notes: i) Except for the initial investment flows, the other cash flows require to be adjusted for inflation effect, at 10 per cent per annum (compounding effect will emerge);

ii) Since the expected return by shareholders is 15 per cent, a discount factor at 15 per cent is applied for evaluation; and

iii) Profitability index is taken as NPV of later cash flows as a ratio to initial flow.

The statement showing computation of NPV and PI is shown in Table 12.

i) NPV and PI of all the three projects are shown in Table 12.

ii) Selection of projects: The absolute maximum level of investment is given at Rs 4,00,000 Hence, there is capital rationing. Ranking the projects in terms of PI is as follows: Project C — I;

project B — II; and Project A — III.

The choice is restricted to a combination of A+C, or B+C.

A+C have a net present value of Rs 29,500, while B+C have an NPV of Rs 32,100.

One has to evaluate the value of surplus funds in the context of the fact that investment will yield income, at less than cost of capital (see Table 13, 14 and 15).

Note: Some renowned authors hold the view that investment of surplus in the market at 10 per cent is not relevant in this case, since it is below the cost of capital. This view is based on a rationale as presented in Table 16.

Conclusion and decision: Select B + C.

4(b)FOR purchase of a car, two alternative models are being considered by a company. As per projections, the car will be used to travel at least 50,000 km per annum. Other relevant information is as follows:

Model A: Life is four years, and price is Rs 200,000. Initial running cost is Rs 2 per km. This cost will go up by 0.50 paise per km each year. After two years of use, the engine has to be replaced at a cost of Rs 50,000.

Model B: Life is six years. Price is Rs 3,50,000. Initial running cost is Rs 1.50 per km. Cost will rise by Re 0.30 per km each year.

A and B: Cost of capital is 12 per cent.

Which of the two models should be purchased? (10 marks)

Solution: The costs of Model A (running costs computed at 50,000 x 2, x 2.50, x 3.00, and so on) and Model B are shown in Table 17 and 18.

The comparative statement of evaluation is given in Table 18, which shows that Model B leads to lower cash outflow on an annuated basis.

Recommend Model B.

(To be concluded)

(Suggested answers to a CA (Final) model paper on management accounting and financial analysis prepared by Prime Academy, Chennai.)

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